Module 1: Understanding Financial Contracts - Leverage | en - 664 - 46462
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if we were to buy the stock for 50 dollars
so this is a situation where we're buying the stock
we're clearly putting 50 dollars up front
and if the stock moved up
to 80 dollars and we were perfectly able to call the top
and sell it for that 80 dollars
we would make a 30 dollar profit
off of a 50 dollar initial investment
so that's a 60 percent gain
that's a 60% gain
on our upront capital
now on the other side if the stock were to go down
to 20 dollars we would lose 30 dollars
of our 50 dollar upfront investment
so it would be a 60% loss
so in the buying the stock
based on the scenario that I painted
we could lose 60% or we could lose 60%
and in terms of the potential upside you can gain
an unlimited amount because the stock can just really go to any possible value
and int terms of loss, when you buy a stock,
the most you can lose is 100%
now let's think about the scenario with the call option
To buy the call option it only costs us 5 dollars
so we only had to put 5 dollars up front
and in this scenario where the stock went up to 80 dollars
we figured out we could profit 15 dollars net of the price of the option
so on a base of a 5 dollars investment
we were able to get 15 dollars of profit
so we got a 300% gain
we were able to get a 300% gain
on the other hand, if the stock went down,
we had no reason to actually excersize our option
so we essentially just lost all the money in the option
We lost 100%
and what I want to show here is that
the option gave us leverage
it gave us leverage
and the term comes from physics
because a lever will give you mechanical leverage
it can allow you to exert more force than you otherwise could
by using that simple tool
and a call option is giving you financial leverage
You're essentially making the same bet
but you're multiplying your potenital gain
or your potenital loss
the stock in the good scenario, you made 60%
but in the call option in the good scenario, you make 300%
we multiplied, we multiplied out gain
But on the downside with the stock we lost 60%
but with the call option we lost 100%
so once again, we multiplied our loss
here it looks like our numbers are still favorable,
because our loss multiplication wasn't as much as our gain multiplication,
but this is really based on some of the numbers I chose
but the important thing to realize is
that if you're dealing with an option
it's the same bet
the bet that the company will go up
you're just putting leverage on your bet,

Let's think about how put options can
give us leverage on a downside,
or should I say a bet that the stock
will go down relative to shorting
and this one is a little more complicated because
shorting is a little bit less intuitive.
But if you were to short a stock, in order to short it,
you might say"hey, I don't have to put any money up front...
"...because I essentially just borrow the stock immediately
and then I would sell it for $50..."
But the reality is that you do have to put some capital
up front because the short can move against you.
Usually you have to put at least 50%
of the value of the short.
So in our "short scenario" you would have to put
at least $25 up front and then you would borrow the stock,
sell it for $50, so essentially you will have $75
to play with that you would eventually have to
use to buy back the stock, but the upfront capital is $25.
Now in our scenario where the stock went down
which was a good thing if you're shorting,
you want the stock, that was your bet
you want the stock to go down.
In this scenario where the stock went down to $20
you made a profit of $30.
You were able to buy that stock for $20
and then give it back to the original person
so you were able to keep that $50 although net for that $20
so you made $30.
So you made $30 on a $25 investment.
So your gain -- you make $25 plus another $5
so that's a 120% gain.
So let me write that down
You made a 120% gain.
Of course in this scenario you gained
when the stock went down.
In terms of loss, here, when the stock went up
the stock went up to $80 we lost $30 by shorting.
We had a 120% loss.
So once again 120% loss.
So it's important to realize in a short situation,
the best thing that can happen for you
is your stock goes to 0.
In which case you can kind of...
buy it back for nothing which means you can keep your $50.
So in the best possible scenario you have to put $25 up
front you can keep the $50 that you got from
borrowing and selling the stock
so you can make a 200% return.
In the worst case scenario
(so the best scenario is this is 200%)
this would be infinite.
So you have to be very careful while you're shorting.
But let's think about the put option.
In the put option we only have to put $5 up front
to actually buy the put and when the stock went down to $20,
when the stock went down to $20
we made $15. So this was a 300% gain.
And on the other side of the equation
when the stock went up the worst we could do
was just lose all of our money.
So the worst thing we can do is just lose 100%.
So once again we were able to multiply,
we were able to multiply our gains relative to shorting
although it's a little more mixed on the downside
because the put gives you a little bit of protection there.

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